Alejandro Zambrano: Why trading professionals use technical analysis

How did you get involved in trading?

I started trading with a personal account at university in 2006, and since 2009 have been working for FXCM as an analyst. I’m a trained economist, and specialise in exploring how to take advantage of market inefficiencies. I’m known for trend following; analysing market participants’ herding behaviour, which I then cross check with the business cycle. This creates trading cases which combine the fundamental and technical worlds.

What place does technical analysis have in a trader’s arsenal?

It’s crucial, and the shorter the investment horizon of the trader, the more weight is usually placed on technical analysis. The reason is simple. Academics have long been puzzled by the weak performance of FX models based purely on fundamentals. No one has really been able to create a model that properly explains variations in FX rates. Nelson C Mark, for example, showed in 1995 that only 33 per cent to 55 per cent of the variance of exchange rates is explained by the fundamentals in the long run. Professionals have also reported difficulties in using fundamental models to estimate FX rates in the short term. In one 1999 survey, only 25 per cent of US and European (excluding UK) professional traders used fundamentals to trade the markets. Most used customers’ order flow and technical analysis to make decisions.

This has given rise to the technical trader. Technical analysis is good at estimating one crucial characteristic of the markets – herding behaviour. Herding behaviour influences all sets of traders – big and small.

Proving that these trends exist is also easy. In 1690, in the coffeehouses of City of London people already tended to herd. Just read Edward Chancellor’s excellent book Devil Take the Hindmost: A History of Financial Speculation. The unstable growth in the value of diving equipment companies and corporations like the East India Company during the period shows just how central to markets these trends have been. And herding behaviour will likely be around for many years to come.

How can traders combine technical and fundamental analysis? 

Even though fundamental models are weak at explaining FX rates, it would be foolish to say that people don’t trade on certain drivers – like the relative change of interest rates or by more or less QE from central banks. A good trader should focus on what is currently driving the markets, and also try to anticipate what drivers will dominate in the future. The fact that traders, to some extent, randomly change their focus is one reason why the academic world has problems estimating exchange rates.

Yet estimating what is currently the focus of the markets is easy – it is being reported by the press. Trying to estimate future drivers is usually not that hard either, but requires more research.

Given that fundamental drivers are crucial for the market and we also know that markets tend to trend, combining these two worlds is a recipe for success.

Alejandro Zambrano is markets analyst for Daily FX.com. You can catch up with his views on the markets at www.dailyfx.com/bulls from 9:30am Monday to Friday